Newsletter February 10, 2021
InvestorsFriend Newsletter February 10, 2021
Even More Sunshine and Roses
Our December 8th newsletter said that as the end of 2020 approached “all is sunshine and roses in the stock market market”. The S&P 500 finished the year up 16.2%. The Toronto stock index was up only 2.2% in 2020 but that put it more than 50% above its March lows. Markets have continued to roar ahead so far in 2021. The S&P 500 is up another 4.1% this new year to date and Toronto is up 5.8%.
Investors should be careful not to be lulled into a false sense of security. It’s ironic that markets feel like a safer bet now than they did back in March. In reality, we now know that last March was a fantastic time to invest.
I recently updated a detailed analysis of the valuation of the S&P 500. This analysis has tended to suggest that the market is over-valued – but it keeps on rising.
Long Term Bonds?
Traditional asset allocation practices and portfolio management advice suggests that most investors should have an allocation to fixed income and that this should include an allocation to long-term bonds. But long-term bonds have had puny yields for years now. Yet they have somehow managed to provide investors with good returns through capital gains for years now. They promise low returns and yet their results have given those that hold them a warm and fussy feeling.
I’ve just updated my in-depth long-term bond article that takes a deep dive into how long-term bonds have managed to outperform their own yields and which explains why that almost certainly cannot continue much longer.
The GameStop Debacle (Predictably) Harmed Retail Investors
In January a huge group of online retail investors were urged to gang-up and cause huge losses to (evil) institutional short sellers by acting together to push the share price of GameStop dramatically higher. This would cause the short sellers to have to buy shares at big losses to “cover” their positions and that buying would help push the stock price even higher. This plan was absolutely destined to cause huge losses to many thousands of retail traders. In fact, the higher they were able to push the price to impose big losses on the short-sellers, the more losses that were destined to be incurred by retail traders. Let’s explore why.
GameStop entered 2021 at a price of about $20 with 65 million shares outstanding. The number of shares sold short actually exceeded 65 million (which can happen) but for my analysis I will assume 65 million shares were sold short.
With 65 million shares sold short, this actually means that there were 130 million shares owned in total offset by 65 million sold short. It’s interesting to contemplate this. It means that, in effect, 65 million shares were conjured out of thin air by the short sellers. Those that bought the shares that were sold by the short sellers would not have been aware that their shares were sort of “phantom”. This also explains why short sellers have to cover any dividends on shares they sell short. The company itself is only going to pay the dividend on the actual number of shares, not on shares artificially created by short selling. I am not suggesting that this is nefarious in any way. It’s just how it works and is interesting to contemplate.
At $20 dollars, and a total of 130 million shares, this would mean a total value of $2.6 billion dollars in investor accounts offset by the short sellers obligation to buy back $1.3 billion worth so that the wealth held by all the shareholders minus the short position was $1.3 billion. And let’s imagine that the the true value of these shares was $40 and many of those holding shares believed that it was the (evil) short sellers that had pushed the price down to $20. (But the short sellers presumably believed the shares were worth less than $20 or at least were headed well under $20.)
The idea was that the massive retail group would act together and buy shares and bid the price up forcing the short sellers (who were deemed evil) to buy back shares at huge losses.
Imagine the situation as the share price got pushed up to say $200. By then most or all of the short sellers would have thrown in the towel and reluctantly bought back shares to close their positions at huge losses. Mission accomplished!
Assuming the short position was now down to zero, there remained 65 million shares outstanding at $200 per share totaling $13 billion. So who owned these shares? Well, the trading volume on the peak days ranged from 33 million shares to as high as 198 million shares. There were nine days when the number of shares traded exceeded the total 65 million shares issued and four days when the volume exceeded even the initial 130 million of shares that counts the actual shares plus all those sold short. So, on multiple days each share traded hands on average more than once. Much of the buying must have been retail investors selling to other retail investors. It’s likely that most of the owners of the total 130 million shares owned in early January would have sold for various gains. And many retail investors would have bought in January and then sold. By the time the share price got to $200 and then ultimately peaked at $483 the 65 million shares must have been owned largely by recent purchasers and most likely mostly retail investors.
Many retail investors would have managed to buy low and sell much higher and made big gains. Some of those gains would have come at the expense of the short sellers. So mission accomplished. But given that the buying volume on the peak days (total trading was 1,206 million shares from January 13 to the end of January) was way beyond the 65 million the short sellers presumably bought back, the owners at and near the peak must have been largely brand new owners who had bought near the highs and who were likely mostly retail investors. Institutional investors would largely have known better than to pay hugely inflated prices.
So, near the highs the 65 million shares must have been owned to a large extent by retail investors. And that was absolutely destined to happen given that it was the retail investors who got together to buy and push the price way up. The short sellers also bought but that was to cover their short positions and in effect those shares simply disappeared into the thin air from whence they were conjured (see above).
So retail investors at the peak ended up being the proud owners of much or most of the 65 million shares at $483 for a total of $31.4 billion. But those shares which had traded for $20 in early January were likely to be actually worth at most $40 and certainly no where near $400 or $200 or even $100.
The share price was then absolutely destined to decline. You can keep anything aloft by blowing on it hard enough, but eventually gravity prevails. In this case, as the share price went back to $50 that was a decline in value of $28 billion dollars compared to the peak value. Some retail investors who bought low but failed to sell would have suffered mostly only paper losses. But it would be extremely distressing to have seen huge gains in their brokerages accounts and then have that disappear. The regret at not selling at high prices would be immense. And many retail investors would have bought near the highs. After all, the trading volume on the day before it peaked was 93 million shares at a range from $249 to $380. A huge portion of the share owners as of the peak must have been recent purchasers at prices above $250. The pain of having bought shares at $250, or $300 or more only to seem them quickly plunge to about $50 would be immense. Some of these investors would have quickly sold and limited their losses. But on Reddit, investors were encouraged to “hold the line”. Some people must have incurred massive losses. Imagine the regret! I really think it’s safe to assume that there will be divorces and even suicides over this.
Some will blame Robinhood for suspending buying of shares. It appears that Robinhood actually had to do that because it got a $3 billion margin call from the clearing house. In any case, once the shares were artificially driven up to over ten times their rational value, a decline, fast or slow, was absolutely inevitable.
In summary, when retail investors collaborated to push share prices way up in order to punish short sellers, it was absolutely inevitable that many of these retail investors would then end up owning most of the vastly inflated shares and the subsequent losses were inevitable. And given the trading volume that was necessary to drive the price up it was inevitable that the the particular retail investors left owning the shares (holding the bag) at the peak would mostly have purchased those shares at very high prices.
February 10, 2021
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